May 17, 2011 / 8:07 PM / 8 years ago

Analysis: Dollar drop? You ain't seen nothin' yet if yuan jumps

NEW YORK (Reuters) - Americans worried about a weaker dollar may want to get used to it.

A crumpled U.S. one dollar bill is displayed in Toronto October 22, 2008. REUTERS/Mark Blinch

Whatever Treasury Secretary Timothy Geithner may say about a strong dollar being in U.S. interests, the likelihood is that the currency will fall sharply in the next few years. And you don’t have to go much further than the pressure Washington is putting on China to revalue the yuan to explain why.

If the yuan appreciates between an annual 5-7 percent against the dollar over the next five years, as some analysts and traders expect, then the dollar is likely to slide anywhere between 20 to 30 percent on trade weighted and other indexes based on baskets of currencies.

And that isn’t just the direct impact of the yuan on those indexes but because a strengthening of the Chinese currency would have a knock-on impact on trade competitors and partners in Asia and other big emerging markets, who would be more comfortable with allowing their own currencies to rise.

Add to that a correlation that has built up between the yuan and the euro — which have sometimes moved in tandem in recent years — and the positive impact of China’s economic growth on the Canadian and Australian dollars and it is difficult to see an argument for a “strong dollar”.

“People have been talking about dollar weakness, but we haven’t seen anything yet,” said Douglas Borthwick, managing director of Faros Trading in Stamford, Connecticut. “We’re going to see dollar weakness across the board. For one, we expect the euro to move to $1.50 soon and go even higher when the yuan is revalued.”

While the dollar had one of its strongest weeks last week, pushing the euro to its lowest since late March on Monday, the strength is seen short-lived by many and the greenback has still lost about 6 percent against the euro this year.

MORE PROBLEMATIC

Further substantial weakness in the dollar over the long run would have major implications for the U.S. and global economies.

It would make the costs of manufacturing in the U.S. much more competitive but raise the costs of imports, potentially squeezing retailers and consumers. It would make it cheaper for foreigners to visit the U.S. and buy American real estate while adding to costs for Americans going abroad.

This should all help improve the U.S. trade and current account deficits, though the government’s budget deficit and debt problems would be more problematic. If the decline in the dollar was too rapid, inflation could climb while China and other nations might reduce their holdings of U.S. treasuries, which could all trigger higher U.S. interest rates and increase the U.S. debt bill.

In the past two weeks, financial markets buzzed with speculation China will further relax its grip on the yuan. The expectations increased after the U.S. Treasury said, based on comments from Chinese officials during high-level talks last week, that the world’s second largest economy now sees further currency appreciation as part of its inflation-fighting strategy.

Beijing has already allowed the currency, which is also known as the renminbi, to strengthen gradually in recent weeks for a gain of 0.9 percent against the dollar in April alone and it has now risen about 5 percent since Beijing loosened a two-year peg to the dollar last June.

Indeed, since first being allowed to trade within a wider band in 2005, it has risen more than 27 percent against the dollar.

But the key to the dollar’s weakness isn’t just the yuan but the impact changes in its value seem to have on other currencies.

Analysts have come to equate yuan gains with a euro rise, partly because the dollar/yuan exchange rate has in the past been quite closely correlated with the ICE dollar index, whose biggest component is the euro with a 58.6 percent weighting.

The other components in the index are the yen (12.6 percent), sterling (11.9 percent), Canadian dollar (9.1 percent), Swedish krona (4.2 percent), and Swiss franc (3.6 percent).

From 2005-2008, the period of flexibility for the yuan before the global financial crisis, the dollar dropped 18 percent against the yuan — not far off the 22 percent decline of the dollar index in the same period.

HIGHER RATES

As investors anticipate greater dollar depreciation, they expect less and less funding of the U.S. current account and budget deficits by China. These deficits will have to be funded elsewhere, possibly by some European nations, such as Germany, that have large surpluses.

Jeffrey Young, chief currency strategist, at Barclays Capital in New York said to attract savings from around the world to finance U.S. deficits, some combination of a weaker dollar against either the euro, yen, or sterling and higher U.S. interest rates becomes necessary.

It’s probably not coincidental that in the periods after China de-pegged in July 2005 and then again in June last year, there was increased buying by China of euros, sterling, and Australian dollars as a way to diversify its reserves.

The impact of a revaluation doesn’t end with gains in the developed world’s currencies. A Chinese move will likely prompt a rise in the currencies of Asian nations that compete with China in export markets and whose economies have also been growing rapidly.

Looking at the Federal Reserve’s trade-weighted dollar index, in which China is already the largest component at 20 percent, the picture is just as grim for the dollar.

The index measures the value of the dollar against the United States’ 26 largest trading partners and is said to be the currency gauge tracked most closely by central bank officials.

The Fed’s broad monthly dollar index adjusted for inflation hit a 38-year low of 81.2781 in April, and could lose another 1.0-1.5 percent on a one-off China revaluation of 5 percent.

Add in the weightings of currencies from other Asian nations, emerging markets elsewhere plus Europe and Canada, and that could easily become a bigger loss of 4-5 percent.

“This is a long-term secular trend for emerging market currencies especially in Asia,” said Tom Higgins, global macro strategist, at Standish Mellon Asset Management. “Asian currencies have long been undervalued and they are on a convergence path with the United States and the G7 more broadly and that’s going to lead to an appreciation.”

And the yuan’s strength isn’t just going to influence currency policy in Asia. Latin American countries, such as Brazil, whose trade with China has soared in recent years would feel more comfortable about their currencies rising if they didn’t fear it would make them less competitive against the Chinese.

Nations such as Australia, Canada and New Zealand that provide resources, such as metals, oil and agricultural products to feed a ravenous Chinese economy, should also see their currencies strengthen as the yuan climbs against the dollar.

EXTREME OR NOT?

So, how far could the yuan jump?

Most economists have factored in a modest five to seven percent yuan revaluation this year despite some assessments that the yuan could be undervalued against the dollar by as much as 40 percent.

This may come mainly through a one-off 5 percent appreciation, or through gradual currency appreciation.

The yuan closed at 6.5060 versus the dollar on Tuesday, compared with Monday’s close of 6.5074.

If the U.S. currency were to drop by the average forecast of an annual 5 percent against the yuan over the next five years, that could mean a 20-25 percent drop in the ICE dollar index, based on that tight correlation between this index and the dollar/yuan.

Borthwick of Faros Trading, though, says he believes the dollar could weaken by as much as 7.8 percent against the yuan annually, which could translate to about a 40 percent fall in the ICE dollar index over a five-year period.

He said the figure corresponds to the fall in the dollar against the Chinese currency from October 2007-March 2008, a period when there was nary a complaint from either the United States or China over the pace of the greenback’s decline.

A 40 percent drop over the next five years may seem extreme to many Americans but it isn’t by global currency market standards. To put it in perspective, the Australian dollar has surged 81 percent in three years since 2008 and many are still buying.

Graphics by Stephen Culp; Editing by Martin Howell

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